Exchange Traded Funds

L.Parvathi Aishwarya
PGDMBIF-024
 Exchange Traded Funds

 An ETF is a basket of securities that is traded on the stock exchange, akin to a

stock. ETFs are listed on a recognized stock exchange. Their units can be
bought and sold directly on the exchange, through a stockbroker during the
trading hours.

 ETFs can be either close-ended or open-ended. Open-ended ETFs can issue

fresh units to investors even post the new fund offer stage, although this tends
to happen selectively on account of the substantial lot sizes involved. In case
of ETFs, since the buying and selling is largely done over the stock exchange,
there is minimal interaction between investors and the fund house
• ETFs can be either actively or passively managed. In an actively-managed ETF,
the objective is to outperform the benchmark index. On the contrary, a passively-
managed ETF attempts to replicate the performance of a designated benchmark
index.
In the Indian context, passively managed ETFs are more prominent.

 ETFs first came into existence in the USA in 1993.

 Benchmark Asset Management Company Pvt Ltd. (BAMC),
a SEBI registered Asset Management Company is the first company to Launch
ETFs in India. It was launched in 2001. It was listed on the Nifty for trade.

 Regulator: SEBI
 Structuring of an ETF

Secondary
Primary Market Market

Seller
Authorised Participant/
Financial Institution Buy/Sell

Market making/
Cash
Arbitrage ETF Units

Creation in
kind NSE
Redemption in kind

Cash ETF Units

Fund Buyer
 The open ended side of an ETF is restricted to a limited set of participants

called Authorised Participants and a certain minimum size is prescribed for the
creation/redemption of units.

 The creation/redemption of units happens in kind. Authorised Participants

who want new ETF units have to pay in the form of a basket of stocks that
mirrors the underlying index. Likewise, when Authorised Participants want
the ETF units to be redeemed they are paid in the form of a basket of stocks
mirroring the underlying index.

 As ETF units are listed on the secondary market (like NSE) investors can buy

and sell ETF units in cash.

 In the secondary market, ETF tend to trade very near to their Net Asset Value

(NAV).
 If the market price of ETF units exceeds their NAV, Authorised Participants
would sell ETF units from their inventory, buy the underlying basket of
stocks from the exchange, and deliver the basket of stocks to the ETFs to
replenish their inventory of ETF units and make an arbitrage profit.

 Likewise, if the market price of ETF units is less than their NAV,
Authorised Participants would buy ETF units from the market, redeem the
units with the ETF, get the underlying basket of stocks, and sell the same in
the market to make an arbitrage profit.
 Types of Exchange Traded Funds

Index ETFs : These are index funds that hold securities and attempt to replicate
the performance of a stock market index.

Commodity ETFs: Commodity ETFs invest in commodities, such as precious

metals and futures on commodities. These ETFs are sometimes called ETCs
(Exchange Traded Commodities)

Currency ETFs : These funds track all major currencies under their brand
currency shares.
Actively Managed ETFs : These ETFs are of recent origin, which were offered
on 25th March, 2008 in US. These are fully transparent funds , which publish their
current securities portfolio on their website daily. They try to outperform the
benchmark index, whereas passively-managed ETFs attempt to replicate the
performance of a designated benchmark index. 

Leveraged ETFs : These funds try to achieve returns that are more sensitive to
market movements than non-leveraged ETFs. Leveraged ETFs can be used by
active traders to play short-term market movements

All-World ETFs. An investor can now achieve global equity diversification by

investing in one ETF. All world ETFs provide coverage on most of the stock
exchanges in both developed and emerging markets.
Sector ETFs: Sector ETFs allow investment in the stocks of different industrial sectors.
Investors can use the sector ETFs either as building blocks for a portfolio or to make
specific sector bets, like investing in energy or technology stocks. Building a portfolio with
sector ETFs, versus a broad based ETF, can provide for more fine-tuning of a portfolio.

Broad-Based Bond ETFs As with a stock ETF, investors can buy a broad-based bond ETF
containing a broad mix of both government and corporate bonds at different maturities. A
broad-based bond ETF can form a core component of a bond portfolio.

Market Capitalization ETFs: One way of looking at stocks is based on their market
capitalizations. Many experts divide the market into large cap, mid cap, and small cap
stocks. Rather than buying a broad-based ETF, an investor can fine tune the strategy by
buying three ETFs: a large cap, a mid cap and a small cap. This approach provides for
greater customization opportunities than buying just one.
Inverse ETFs: Investing in an inverse ETF means that you profit from a decline in the
value of an underlying benchmark, such as the NASDAQ.

Yield Curve Bond ETFs Some bond funds allow investors to buy Treasury bonds based on
different maturities along the yield curve. The longer Treasury ETFs are good for
speculating on changes in interest rates, while the short-term bond funds are a good place to
park money that typically provides a better return than money market funds.

Inflation Protected Bond ETFs: Treasury inflation protected securities (TIPS) bonds pay
interest equal to the Consumer Price Index plus a premium. They provide a hedge against
inflation and are designed to outperform regular bonds when inflation expectation rises.
Quantitatively based ETFs use enhanced indexing to offer investors the potential
to outperform a benchmark index. The objective is to quantitatively identify a
subset of stocks from an index that are expected to outperform. Quantitative
indexing uses predefined rules to rank stocks based on a number of different
characteristics, which can include both fundamental and technical factors.
 Applications of ETFs

 Efficient Trading : ETFs provide investors a convenient way to gain market exposure

viz. an index that trades like a stock. In comparison to a stock, an investment in an ETF
index product provides a diversified exposure to the market. Depending on the index,
investors may obtain exposure to countries/ markets or sectors.

 Equitising Cash : Investors with idle cash in their portfolios may want to invest in a

product tied to a market benchmark like an index as a temporary investment before

deciding which stocks to buy or waiting for the right price.

 Managing Cash Flows : Investment managers who see regular inflows and outflows

may use ETFs because of their liquidity and their ability to represent the market.
 Diversifying Exposure : If an investor is not sure about which particular

stock to buy but likes the overall sector, investing in shares tied to an index or
basket of stocks provides diversified exposure and reduces stock specific risk.

 Filling Gaps : ETFs tied to a sector or industry may be used to gain exposure

to new and important sectors. Such strategies may also be used to reduce an
overweight or increase an underweight sector.

 Shorting or Hedging : Investors who have a negative view on a market

segment or specific sector may want to establish a short position to capitalize

on that view. ETFs may be sold short against long stock holdings as a hedge
against a decline in the market or specific sector.
 ETFs Vs Stocks & Mutual Funds
Functionality ETFs Stocks Mutual Fund
Units
Real time trading and pricing Yes Yes No
throughout market hours
Ability to put limit orders Yes Yes No
Can be purchased through NSE Yes Yes No
broker and/or online trading
account
Can be traded real time on the NSE Yes Yes No
Arbitrage possible between futures Yes Yes No
and cash market
Diversification possible with a Yes No Yes
single unit
Returns at par with the Yes No Yes
market/index
Intraday Trading Yes Yes No
Paper less trading Yes Yes No
Exit load No No Yes
 Advantages of ETFs
 
 Buying and selling flexibility: ETFs can be bought and sold at current market prices at

any time during the trading day

 Transparency - ETFs, whether index funds or actively managed, have transparent

portfolios and are priced at frequent intervals throughout the trading day

 Delivery in demat accounts

 Minimum trading lot just one unit

 One can put limit orders

 Disadvantages of ETFs

 Brokerage has to be paid for trading in ETFs

 Investors need to have a demat and a trading account, with a SEBI registered

stockbroker, for investing in ETFs.